Question on using severance to pay 401K loan before filing?

[jimnbene]

I recently was laid off from my job. I have a 401K loan for about $30K. I have severance coming which will be (after taxes) about $35K. I am wanting to pay the 401K loan back before I file as if I don't it will mean that I am going to receive that as a "distribution" which I assume will be looked at as income and certainly will cause me to pay taxes and possibly penalties (I am over 55 and 401K regs say that if you are over 55 and leave a job, you don't pay the penalties).

My question is, how would this loan repayment, essentially to myself as it is put back in the 401K, be viewed upon filing either a 7 or a 13?

If anyone can answer this question, I would love to hear the answer.

[JRScott]

It would be considered a preferential payment to yourself.....if I"m not mistaken.

You'd need to wait at least 2 years after doing it to file.

[jimnbene]

While I understand the point that it might be considered a preferred payment to myself, wouldn't the fact that I would only incur significantly more debt in terms of taxes and possible penalties by being forced to take a distribution instead of repaying the loan be considered?

I mean those tax debts can't be avoided even in bankruptcy, so they seem to be worse debts to be carrying forward.

Not filed yet, just trying to figure out what to do.

Hoping to get a better idea as I was hoping that someone had this dilemma before.

[catleg]

Just as there's no such thing as a debt to yourself, there's no such thing as a preferential payment to yourself. Since not paying the loan would result in a tax liability, and since assets in and payments to ERISA plans are generally exempt, I'm pretty sure you wouldn't have any problems doing that. You should probably ask a lawyer to be certain.

There is no reason that you can't restructure your assets to maximize your exemptions while you plan going into BK. It's just like maximizing your legal tax deductions.

[Pizza]

I've been digging and digging on this one... can't find a definite answer. I guess the million dollar question is if turning non-exempt assets (such as cash) into exempt assets like a 401k, as described here, is allowed. If anyone knows, it's a darn good question.

[Pizza]

HHR, HRx, Angelina, lrprn... anyone with some expert advice on this one?

I'm still researching this one. After a couple of months, I could rollover my 401k with my new job, but the loans repayments would come back after 6 months and I started thinking about the tax liability too. A small worry, but Google's not helping much. I wish I could find a sure-fire answer. Here's my findings:

1) One of the H's here brought up a legal reference that tends to suggest you can make repayments without worry.
2) One particular bankruptcy case was dismissed because someone used huge repayments as part of 'necessary expenses' on the means test.
3) Chapter 13 plans tend to want to exclude repayments and/or contributions as part of the budget.
4) There is a conflict between sources as to whether converting exempt assets (cash) to non-exempt assets (401k) is considered fraudulent, and
5) Since you are technically paying back yourself, the loans aren't dismissed in BK.

Sorry, I can't find a lot of information about repayments before BK. This is a pretty big question, since it affects the future far beyond BK.

[AngelinaCatHub]

It would be considered a preferential payment to yourself.....if I"m not mistaken.

You'd need to wait at least 2 years after doing it to file.

This time, I disagree with JRS (rare).

You would execute a taxable event. It would hurt you more than anything regarding bk or payback. It was your money you loaned to yourself so you are not making anything preferential as it is your money, not a creditor's.

Do this and NEVER EVER TAKE RETIREMENT MONIES, as they are always exempt. Of course I have to say, ask your lawyer, but PLEASE put the money back. You have no idea of it's future value and it's immediate pain if you write it off. It will cost you greatly in many ways.

'Hub

[AngelinaCat]

If I remember right, it seems like a trustee questioned someone's repayment back to a 401(k) plan in the last couple of months or so. But it did not stand up according to that poster. That concerned repayments within the BK. You are talking about repaying before you BK. There may have been other issues involved. I did not offer an opinion on that thread, so it may be difficult to find. I will look for it and see how it played out.

Now, having said all that, you have not filed. In my opinion, you should pay yourself back, and forget that that 401(k) account exists.

You will be having some planning to do before you actually do file, so time willl be on your side. Don't forget that due to your circumstances, you may be eligible for Unemployment Compensation. Go get that coming.

Good luck and Best Wishes~~~

[Pizza]

This time, I disagree with JRS (rare).

You would execute a taxable event. It would hurt you more than anything regarding bk or payback. It was your money you loaned to yourself so you are not making anything preferential as it is your money, not a creditor's.

Do this and NEVER EVER TAKE RETIREMENT MONIES, as they are always exempt. Of course I have to say, ask your lawyer, but PLEASE put the money back. You have no idea of it's future value and it's immediate pain if you write it off. It will cost you greatly in many ways.

'Hub

Thank you so much. I didn't have any idea in '06 that I would even be looking into BK. Won't make that mistake again. I will ask my lawyer about it, of course, I hope you're right.

[Pizza]

If I remember right, it seems like a trustee questioned someone's repayment back to a 401(k) plan in the last couple of months or so. But it did not stand up according to that poster. That concerned repayments within the BK. You are talking about repaying before you BK. There may have been other issues involved. I did not offer an opinion on that thread, so it may be difficult to find. I will look for it and see how it played out.

Now, having said all that, you have not filed. In my opinion, you should pay yourself back, and forget that that 401(k) account exists.

You will be having some planning to do before you actually do file, so time willl be on your side. Don't forget that due to your circumstances, you may be eligible for Unemployment Compensation. Go get that coming.

Good luck and Best Wishes~~~

Thank you, and I've already been through the unemployment thing, lucky, VERY lucky to find another job so quickly.

[JRScott]

This time, I disagree with JRS (rare).

You would execute a taxable event. It would hurt you more than anything regarding bk or payback. It was your money you loaned to yourself so you are not making anything preferential as it is your money, not a creditor's.

Do this and NEVER EVER TAKE RETIREMENT MONIES, as they are always exempt. Of course I have to say, ask your lawyer, but PLEASE put the money back. You have no idea of it's future value and it's immediate pain if you write it off. It will cost you greatly in many ways.

'Hub

Youre repaying a loan which is a debt to a creditor. Repaying more than 600 dollars in the 90 days prior to filing is a preferential payment.....

[Flamingo]

Anytime you are dealing with taxable income, there is a trail and all this will have to be divulged prior to filing BK. The look back period for amounts this size could be one year. We had to list for one year prior to filing amounts of any payments, transfers, checks written, cash withdrawn or deposits in excess of I believe $1,000. This was not a small loan - you are talking major cash. Best of luck to you!

[pcn]

We considered doing this and were advised by our atty that it would jeopardize any protection that we have through bk. By moving money back into the 401k it would be considered trying to protect assets, and would cause the case to be dismissed, as well as invoke some penalty barring us from doing anything with the debts in the future.

[AngelinaCatHub]

Well, I've been wrong before (see my signature).

Bankruptcy and 401k Loans – New Guidance
Posted at June 8, 2009

Bankruptcy seems to be all the talk recently given GM’s filing last Monday. Last week we discussed how your 401k account is protected, in a bankruptcy proceeding, from your creditors. This special protection is extraordinary and something to be guarded closely. We also discussed how this protection could be lost if you are not careful. Coincidentally, there is a new court case within the last week that illustrates this.

New Laws – New Challenges

There are several ways to file for bankruptcy, but filing under Chapter 7 is certainly the most popular. Under a Chapter 7 filing, a debtor’s obligations are dismissed; the best possible outcome. A less popular filing, is under Chapter 13 where a debtor is expected to pay a significant amount of his debts, but less than 100%.

To avoid abuse of Chapter 7, Congress amended the bankruptcy laws in 2005 and inserted a “means test” that basically looks at a debtor’s ability, “means”, to repay his debts before granting him relief. In other words, if you have the means to repay debt, you will be required to do so.

401k Loans – Beware!

In this case, the debtor had taken out a 401k loan 2 years (!) before he filed for bankruptcy and was repaying the loan every month. He argued that the 401k loan repayments were a “necessary expense” and therefore could not be considered for repayment of other debts, largely $31,000 in consumer loans.

The court disagreed. In a nut shell, the court said his 401k Loan was a debt to himself, and he did not have the right to repay himself before others. The court disallowed the loan repayments as “necessary expenses” and presumably he will now have to pay down other debt with those monies.

The Nasty Implications

The result for our debtor will not be pretty. The amount he was repaying every month on his 401k Loan was over $700. This amount will be redirected to other debtors as his Chapter 7 filing was rejected. He will default on the outstanding balance of the loan in his 401k plan and will owe Federal and State Income taxes, as well as a 10% Federal Penalty on the amount. His 401k account will be reduced, obviously, by the amount of the outstanding loan, and long term, his overall retirement account will suffer by this amount plus earnings.

As we discussed last week, not all 401k Loans are bad, but they should be taken as a last resort. This most recent case from the 9th Circuit (Egebjerg v. Anderson) just further reinforces the unforeseen consequences such loans can have.

http://www.401k-guy.com/2009/06/08/bankruptcy-401k-loans/

With apologies to JRS. (right again, and Flamingo)

[Pizza]

Well, so much for that, LOL...

No big deal. It's not as much a nest egg as maybe a nest jellybean that I'm dealing with... I'll leave it alone until after BK is filed & just take the tax penalty (the creditors get the refund anyway as I understand).